1/14/2011 @ 12:00PM

Health Care Stocks: Think Tech, Not Big Pharma

Typically viewed as a safe haven in tough times, the healthcare sector has been left in the dust of late as the broader market rallied. With earnings season under way health care companies are still facing uncertainty around the health care reform passed by Congress last year, but analysts say 2011 may be better following 2010′s sharp underperformance, particularly in certain areas.

One such area is biotech. Large cap biotech stocks are trading at just 10 times forward earnings compared with 15 times for the S&P 500, says RBC Capital Markets analyst Michael Yee. He expects biotech stocks to produce an average 10% return this year, led by companies like
Amgen
, which will launch its bone drug Prolia this year with a focus on its potential for cancer patients. Lee predicts Amgen, now trading at $56.63, can gain trade in the mid-$60 range by year’s end.

Coming up on March’s one-year anniversary of the passage of the health care reform bill, many aspects of the legislation are still in the early stages and Republicans in Congress are threatening efforts to repeal the package. The view among many analysts though is that ultimately the reform will result in more persons in the health care system. Couple that with an aging population and a push for more efficiency, and makers of generic drugs, medical devices or cost-effective technology geared toward health care professionals are poised to benefit.

With hospitals and physicians converting their medical records to digital systems after President Obama’s mandate that requires all records be digitized by 2014, the next three years will be important for healthcare IT companies to secure revenue-boosting projects. Caris & Company analyst Leo Carpio says the fact that 70% of the program’s incentives will be paid out in the next few years sets the stage for “a land-grab for the health IT business.” Some of the players in that fight are
Allscripts Healthcare Solutions
and
Cerner
.

Pharmaceuticals, which make up more than 50% of the health care sector, are in a tricky spot in the face of health care reform, impending regulations and, perhaps most importantly, a looming “patent cliff” of expirations on some of the industry’s biggest revenue-drivers, including
Pfizer
‘s blockbuster cholesterol drug Lipitor. In 2011 an estimated $20 billion in drug revenue will move to generics, and analysts say there are no new drugs in the late stages of the pipeline to pick up the slack. Meanwhile, the report cards on acquisitions designed to replenish those pipelines are still pending; on Thursday,
Merck
revealed an issue with one of the most exciting experimental drugs it brought in with its purchase of Schering Plough. (See “Merck Learns There Is No Magic Pill.”)

“We are staying away from pharmaceuticals,” says Cynthia Axelrod, a research analyst for Glenmede Investment Management. “They all have cost-cutting stories, and you start running out of room in that. Now they face a patent cliff and they have nothing in the pipeline.”

A better play, Axelrod says, is in companies like
Express Scripts
, a pharmaceutical benefits management company that links prescription drugs with patients and insurers, aiming to save spending and move to generics where they can.

Others view pharmaceuticals as a potentially rewarding speculative play, given the potential for M&A in a space where the biggest players are desperate to produce new revenue drivers. “The patent cliff that is expected could contribute to some speculation on the stocks over the next year,” says RBC’s Yee.

Last year’s slowdown in elective procedures and in tightening hospital budgets could be worrisome signals for medical device and equipment makers. Devices will also face 2.3% excise tax in 2013, affecting their earnings. That may be a cause for bearishness on the space, but RBC analyst Glenn Novarro says diversified plays like widely-held
Johnson & Johnson
and
Abbott Laboratories
are a way to gain exposure to the positive aspects of health care trends without putting all your eggs in one basket. Their diversification, strong cash flow and solid balance sheets will allow them to “create stronger earnings growth than pure medical device companies,” he says.